Chapter 1

Basic concepts

Introducing the course

“The whole of the science is nothing more than the refinement of everyday thinking”. Albert Einstein

Learning Objectives

This chapter introduces you to the issues macroeconomists study the tools macroeconomists use some important concepts in macroeconomic

analysis

Important issues in macroeconomics

Why does the cost of living keep rising? Why a large number of people remain

unemployed? What causes recessions?

Can the government do anything to combat recessions? Should it?

Macroeconomics, the study of the economy as a whole, addresses many topical issues:

Important issues in macroeconomics

What is the government budget deficit? How does it affect the economy?

Why does a country have trade deficit ? How does a country have balance of payments

surplus? Why are so many countries poor?

What policies might help them grow out of poverty?

Macroeconomics, the study of the economy as a whole, addresses many topical issues:

Movement of macroeconomic indicators in Nepal

Movement of Macroeconomic Indicators

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NER Index

Why learn macroeconomics?

The macroeconomy affects society’s well-being.

For example: each one-point increase in the unemployment rate in the US is associated with:

920 more suicides650 more homicides4000 more people admitted to state mental institutions3300 more people sent to state prisons37,000 more deathsincreases in domestic violence and homelessness

(Source: N. Gregory Mankiw, Macroeconomics)

The macroeconomy affects society’s well-being.

For example: each one-point increase in the unemployment rate in the US is associated with:

920 more suicides650 more homicides4000 more people admitted to state mental institutions3300 more people sent to state prisons37,000 more deathsincreases in domestic violence and homelessness

(Source: N. Gregory Mankiw, Macroeconomics)

Some more on macroeconomics

Thus, the Macroeconomics also called the ‘income theory’ looks at the total economy:

Total output and income The level of unemployment and employment The amount of money in circulation The level of prices and the rate of inflationThus, in macroeconomics, we deal with the national economic goals

such as full employment, control of inflation, economic stability and growth.

Remember as micro deals with individual, macro with aggregate. Thus, the difference is in “I” and “A” . I for individual (micro) and A for aggregate (Macro).

Some more on macroeconomics

The history of present day macroeconomics started with the publication of J.M. Keynes’ “ The General Theory of Employment, Interest and Money” in 1936.

Before the General Theory, microeconomics dominated the entire analysis under the assumption of full employment.

But the Great Depression of 1930s broke this belief with a number of devastating outcomes.

Basic economic problems issue Resources/Inputs: A society’s resources consist of natural endowments

such as land, forests, and minerals (traditionally referred as land);

Human resources both physical and mental (traditionally referred as labor).

Manufactured aids to production such as tools, machinery, and buildings (commonly known as capital).

Entrepreneurs: Organization of production, innovation of new goods and technologies and the bearing of risk and uncertainty.

Basic economic problem issue Resources: Resources are used to produce the outputs

that people desire. These outputs are divided into goods and services.

Goods are tangibles (car, shoes etc) and services are intangibles (e.g. haircuts, and education).

Basic economic problem issue Resource scarcity (Remember a saying referring to

scarcity, “I did the best I could with what I had.”) Scarcity occurs because our limited resources and

time can only yield limited production and income, but people’s wants are virtually unlimited. Output is produced by using knowledge (technology) to apply energy to a blend of resources. Production, in turn, generates the income people spend on the limited goods and services available.

Basic economic problem issue Resource scarcity: Is there a balance?

Scarcity

Limited resources and time (labor, land,

capital, entrepreneurship) Virtually unlimited human wants (food, clothing, shelter, security, comfort, medicine, jewelry, affection, recreation, and a number of others)

Basic economic problem issue Economic surplus: the benefit of any action, minus its

cost, where benefit is measured by the marginal willingness-to-pay to undertake that action, and the cost is the marginal opportunity cost of undertaking that action. Also known as "total surplus" or “social surplus.”

Economic Efficiency: the maximization of economic surplus.

Economic efficiency : it is achieved when we produce the combination of outputs with the highest attainable total value, given our limited resources. It can be decomposed into: allocative, productive, and distributive.

Basic economic problem issue Allocative efficiency-What: Requires the pattern of

national output to mirror what people want and are willing and able to buy.

Productive efficiency-How: Requires minimizing opportunity cost for a given value of output. Maximum output using given resources. Remember, “too many cooks spoil the broth.”

Distributive efficiency-Who: Requires that specific goods be used by the people who value them relatively the most.

Basic economic problem issue Pareto efficiency: A situation where no one can be

made better-off without making someone else worse-off (Zero sum game).

Pareto improvement: A change that actually makes someone better-off without making anyone else worse off. Difficult!

“Potential” Pareto-improvement: A change that makes some people better-off by enough that they could compensate any losers with money so that everyone is better-off. Also known as "more efficient" or "economic improvement."

Opportunity cost

Choosing any scarce thing forecloses other options, such lost options are economic (or opportunity) costs.

Opportunity cost is the value of the best alternative surrendered when a choice is made.

Every time a choice is made, opportunity costs are incurred. Think your college education versus the job you could have.

Suppose you are paying Rs. 200,000 for your education but you could have earned Rs. 400,000 if you had worked for 4 years. This means opp. cost of your education is Rs. 600,000.Higher your earning potential, higher your opport cost of the job.

Stocks vs. Flows

A flow is a quantity measured per unit of time. E.g., “U.S. investment was $2.5 trillion during 2006.”

Flow Stock

A stock is a quantity measured at a point in time.

E.g., “The U.S. capital stock was $26 trillion on January 1, 2006.”

Now you try:

Stock or flow? the balance on your credit card statement how much you study economics outside of

class the size of your compact disc collection the inflation rate the unemployment rate The broad money on Mid-July of each year.

Production possibility boundary Production possibility boundary illustrates three

concepts: scarcity, choice and opportunity cost. Scarcity is indicated by the unattainable

combinations above the boundary; Choice by the need to choose among the alternative

attainable points outside the boundary. Opportunity cost by the negative slope of the

boundary. (See the next slide)

Production possibility boundaryAn example of production possibility frontier (PPF)

Economic organizations

Traditional economy: an economy in which behavior is based primarily on tradition, custom, and habit. Young men follow their fathers’ occupations. Women do what their mothers did.

In this economy, what to produce, how to produce and how to distribute are determined by traditions.

In rural areas of the less developed economies, we still find this type of society.

Economic organizations

Command systems: Economic behavior is determined by some central authority, usually the government, which makes most of the necessary decisions on what, how and for whom. Since the planning is done at the central level, this type of economy is also called centrally planned economy.

By the end of 1980s, one-third of the world’s economies were command economy. But today, only a few. Most common examples are China, Cuba, North Korea.

Economic organizations

Market systems: Decision about the resource allocation are made without any central direction. Rather, it is made independently by individual producers and customers. Thus, it is also called market economy or free market economy.

Decision making is decentralized but coordinated. The coordinating device is the set of market determined prices. Therefore, market economy is also called price systems.

Economic organizations

Mixed systems: No system is perfectly command or market. The degree of weightage varies. In command economy, heavy weight is given to the central planning and in market systems heavy weight is given to the decentralized decisions making in response to market signals.

US, France, Canada, and Singapore rely heavily on market systems. And China, North Korea and Cuba on central planning.

However, there are some state regulations even in the US in environmental protection, restriction on the import of shoes and textiles etc. Also in command economies there are some market signals such as the presence of multilateral in China.

Black or underground economy Black economy is also called Grey/Informal/Unofficial

economy. Private cash transactions in this economy are unreported and thus untaxed. Not only illegal activities, it also includes legal transactions that are not reported to the tax authorities and the income from which goes untaxed and unreported is also included there. Macedonia is taken as the case. If the black economy is stopped, Macedonia would go bankrupt. Marijuana, pornography and illegal labor create the black economy even in countries like the US.

Country% of black economy: Russia 50-60%, England and America 5-10%, Italy 30-40%.

Black or underground economy Like black economy, the underground/shadow

economy consists of all commerce on which applicable taxes are being evaded. Thus, used black or underground interchangeably. Includes not only legally-prohibited commerce (e.g. drugs, prostitution, work done by illegal migrants, smuggling of commodities, and gambling) but also trade in legal goods and services because some income is not reported and consequently taxation is evaded through money laundering, payments in cash or other means.

Black or underground economy Typically cash transactions to evade traceability by

government. Also complex financial operations involving the use of multiple subsidiaries and tax heavens. The growth of online commerce can increase this economy. For example: eBay has over 40 million regular users. The seller is legally responsible to pay taxes but it is evaded.

Economic models Mathematical presentation of economic

theories designed to show the relationship among variables.

Thus, …are simplified versions of a more complex reality irrelevant details are stripped away

…are used to show relationships between variables explain the economy’s behavior devise policies to improve economic performance

Example of a model: Supply & demand for new cars shows how various events affect price and

quantity of cars assumes the market is competitive Variables:

Q d = quantity of cars that buyers demand

Q s = quantity that producers supply

P = price of new cars

Y = aggregate income

Ps = price of steel (an input)

The demand for cars

demand equation: Q d = D (P,Y )

shows that the quantity of cars consumers demand is related to the price of cars and aggregate income

Digression: functional notation General functional notation

shows only that the variables are related.

Q d = D (P,Y )

A specific functional form shows the precise quantitative relationship. Example:

D (P,Y ) = 60 – 10P + 2Y

The market for cars: Demand

Q Quantit

y of cars

P Price

of cars

D

The demand curve shows the relationship between quantity demanded and price, other things equal.

demand equation:

( , )dQ D P Y

The market for cars: Supply

Q Quantit

y of cars

P Price

of cars

D

supply equation:

( , )ssQ S P P S

The supply curve shows the relationship between quantity supplied and price, other things equal.

The market for cars: Equilibrium

Q Quantit

y of cars

P Price

of cars S

D

equilibrium price

equilibriumquantity

The effects of an increase in income

Q Quantit

y of cars

P Price

of cars S

D1

Q1

P1

An increase in income increases the quantity of cars consumers demand at each price…

…which increases the equilibrium price and quantity.

P2

Q2

demand equation:

( , )dQ D P Y

D2

The effects of a steel price increase

Q Quantit

y of cars

P Price

of cars S1

D

Q1

P1

An increase in Ps reduces the quantity of cars producers supply at each price…

…which increases the market price and reduces the quantity.

P2

Q2

S2

supply equation:

( , )ssQ S P P

Endogenous vs. exogenous variables The values of endogenous variables

are determined in the model.

The values of exogenous variables are determined outside the model: the model takes their values & behavior as given. In the model of supply & demand for cars,

endogenous: , , d sP Q Qexogenous: , sY P

A multitude of models

No one model can address all the issues we care about.

e.g., our supply-demand model of the car market… can tell us how a fall in aggregate income affects

price & quantity of cars. cannot tell us why aggregate income falls.

A multitude of models

So we will learn different models for studying different issues (e.g., unemployment, inflation, long-run growth).

For each new model, you should keep track of its assumptions which variables are endogenous,

which are exogenous the questions it can help us understand,

and those it cannot

Prices: flexible vs. sticky

Market clearing: An assumption that prices are flexible, adjust to equate supply and demand.

In the short run, many prices are sticky – adjust sluggishly in response to changes in supply or demand. For example, many labor contracts fix the nominal wage

for a year or longer many magazine publishers change prices

only once every 3-4 years

Prices: flexible vs. sticky

The economy’s behavior depends partly on whether prices are sticky or flexible:

If prices are sticky, then demand won’t always equal supply. This helps explain unemployment (excess supply of labor) why firms cannot always sell all the goods

they produce Long run: prices flexible, markets clear,

economy behaves very differently

Equilibrium and Disequilibrium Equilibrium A situation in which nobody has any

immediate reason to change their actions, so that the status quo can continue, at least temporarily. This is a state of balance between opposing forces/actions.

In Microeconomics, the simplest form of equilibrium analysis looks at a single market. The intersection of demand and supply gives an equilibrium price (see the previous figures).

Equilibrium and Disequilibrium Equilibrium In Macroeconomics, equilibrium refers to

situations when activity and price levels are such that the plans of various groups such as savers and investors are consistent, so that they can all be implemented. Macroeconomic model covers thousands of different goods and services supplied and demanded in the market. In macroeconomic equilibrium, AD and AS curve intersect each other (draw graph).

Equilibrium and Disequilibrium Equilibrium In game theory, an equilibrium in strategies

exists if, given the strategies that all other agents are using, no individual agent finds any change of strategy to be desirable. Such an equilibrium may involve all parties taking the others’ strategies as given: this is called a Nash Equilibrium.

Equilibrium and Disequilibrium Disequilibrium A situation in which plans can not be carried

out. Disequilibrium can arise in particular markets, in the level of activity as a whole, or in the external relations between countries: it is the normal state of the real world economy. It produces discrepancies between ex ante plans and ex post facts, which lead to a dynamic process of change.

Value added

definition:

A firm’s value added is

the value of its output minus

the value of the intermediate goods the firm used to produce that output.

Exercise:

A farmer grows a bushel of wheat and sells it to a miller for $1.00.

The miller turns the wheat into flour and sells it to a baker for $3.00.

The baker uses the flour to make a loaf of bread and sells it to an engineer for $6.00.

The engineer eats the bread.

Compute & compare value added at each stage of production

and GDP

Business Cycle

Business cycle: Alternating periods of expansion and contraction in economic activity.

Classified into (a) the peak or boom, (b) a recession or contraction (c) a depression or trough, and (d) a recovery

Business CycleThe peak or boom Optimum level of economic activity is achieved and

factors of production are fully employed. Demand, output, employment and income are at a high

level Prices rise but the factor share of income does not rise in

proportion to price rise. Rise in expectations lead to high lending, investment,

and demand for consumables. The expansionary process becomes self reinforcing,

leading to full employment and inflationary price hike. Finally, scarcity of resources and stable propensity to

consumption leads to recession.

Business Cycle

Recession or contraction A situation when demand is sluggish, real

output is not rising and unemployment is increasing. A recession is usually identified when real GDP falls for two consecutive quarters. It is not severe as a depression.

Consumption demand falls (think its effect) Labor demand also declines Inflation declines or deflation occurs Business profits also fall

Business Cycle

Depression/slump or trough A prolonged period of abnormally low

economic activity and abnormally high unemployment. This is often accompanied by a tendency for prices to fall, and by a fall in the relative prices of primary products as compared with those of industrial products.

Price mechanism collapses and output slumps heavily.

Begins with some price shock, stock market crash or similar other large shocks.

Business Cycle

Recovery Output and employment are moving back from their

slump troughs towards normal levels Consumption demand starts to increase Labor demand increases Inflation increases Investment turns out to be profitable Rising expectations about economic activities so

that demand, investment, employment, income, output, price and profits all are expanding.

Chapter SummaryChapter Summary

Macroeconomics is the study of the economy as a whole, including growth in incomes, changes in the overall level of prices, the unemployment rate.

Macroeconomists attempt to explain the economy and to devise policies to improve its performance.

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Chapter SummaryChapter Summary

Economists use different models to examine different issues.

Models with flexible prices describe the economy in the long run; models with sticky prices describe the economy in the short run.

Macroeconomic events and performance arise from many microeconomic transactions, so macroeconomics uses many of the tools of microeconomics.

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